Tax devolution to states

Tax devolution to states

Subject: Polity

Section :Federalism

Concept :

• The Centre’s tax devolution to the States, which has been consistently falling short of the Finance Commission’s recommendation, will hit a five-year low in FY24, according to an analysis of Budget 2023-24 by Emkay Global Financial Services .
• Tax devolution in FY24 is estimated to hit a five-year low of 36.5 per cent.
• The 14th Finance Commission had recommended a devolution of 42 per cent of Central taxes to States, but after Jammu and Kashmir was carved out into two Union Territories, the final report of the 15 th Finance Commission recommended the transfer of 41 per cent.

Reasons for Low tax devolution

• Increasing cess&surcharges :
• Decline in tax devolution is largely due to increasing cess and surcharges imposed by the Centre.
• Cess and surcharges are part of central taxes but not part of the divisible tax pool and do not have to be shared with States.
• In fact, cess and surcharge has grown at a faster pace than gross tax revenues.
• The 15 th Finance Commission said that the divisible pool, as a percentage of the gross revenues of the Union, has been consistently falling as more and more resources are raised through non-shareable cesses and surcharges.
• Total 15th Finance Commission transfers (devolution + grants) constitutes about 34% of estimated Gross Revenue Receipts to the Union.

• Discontinuation of GST compensation :
• Other reason for the Centre’s devolution coming down in FY24 could be the discontinuation of compensation for States (to be paid to states to meet the shortfall in indirect tax revenue below a specified threshold, due to the introduction of GST) ending in June 2022.
• Going ahead, the compensation cess will be used for servicing debt that the Centre took on behalf of the States during the Covid-19 pandemic. For FY24, market loans worth ₹78,100 crore are due for redemption.

What is Tax Devolution?

• Tax Devolution is to make recommendations for distributing the net proceeds of taxes between the Union and the states.
• It is one of the key responsibilities of a finance commission according to Article 280 (3) (a) of the Constitution.
• Vertical Devolution :distribution of net taxable income between the Union and states.
• Horizontal Devolution :distribution of net taxable income between the states.

Allocation to states

• Central transfers to states include devolution from a divisible pool of taxes, transfers towards Centrally Sponsored Schemes, Finance Commission grants, other transfers and capex loans.
• Of these, tax devolutions accounts for over 70 per cent .
• Tax devolved to States are untied funds and hence states are free to spend them as per their discretion.

Finance Commission Grants

• Revenue Deficit Grants to States:
  • Revenue deficit grants emanate from the requirement to meet the fiscal needs of the States on their revenue accounts that remain to be met, even after considering their own tax and non-tax resources and tax devolution to them.
  • Revenue Deficit is defined as the difference between revenue or current expenditure and revenue receipts, that includes tax and non-tax.
• Performance Based Incentives and Grants to States:
  • These grants revolve around four main themes.
  • The first is the social sector, where it has focused on health and education.
  • Second is the rural economy, where it has focused on agriculture and the maintenance of rural roads.
  • Third, governance and administrative reforms under which it has recommended grants for judiciary, statistics and aspirational districts and blocks.
  • Fourth, it has developed a performance-based incentive system for the power sector, which is not linked to grants but provides an important, additional borrowing window for States.
• Grants to Local Governments:
  • Along with grants for municipal services and local government bodies, it includes performance-based grants for incubation of new cities and health grants to local governments.
  • In grants for Urban local bodies, basic grants are proposed only for cities/towns having a population of less than a million. For Million-Plus cities, 100% of the grants are performance-linked through the Million-Plus Cities Challenge Fund (MCF).
• Statutory Grants:
  • Article 275 authorizes Parliament to offer grants to states in need of financial help, rather than to all states. Every year, these funds are charged to India’s Consolidated Fund.
  • Aside from this basic provision, the Constitution also provides for specific funds to promote the welfare of scheduled tribes in a state or to improve the standard of administration in scheduled areas in a state, such as Assam.
  • The Finance Commission recommends the states that receive statutory grants (both general and particular) under Article 275.